Thanks Jeff! We wrote this article with the assumption that a legal entity for the start-up had already been formed but that's a good point.
Forming a start-up is a lot like getting married. It’s not a decision to be taken lightly, and to be successful, the founders’ individual interests have to take a back seat to the collective interests of the new company.
There’s also a lot of important legal stuff to tackle—it’s kind of like a pre-nup, only way more complicated. Unfortunately, though, many entrepreneurs are inclined to defer this paperwork until they get funded, or memorialize decisions on the back of a napkin. And while this might be fine for your business plan, it’s crucial that the major issues—ownership, control, and intellectual property, to name a few—are formalized before business gets underway.
But given your limited resources, how do you prioritize which decisions require your focus, time, and (not trivial) legal expense? We’ve identified three of the most important issues to get right from the get-go.
1. Formalize Control
Before you start making any kinds of decisions, make sure you have control arrangements worked out between you and your co-founders. More importantly, get them clearly spelled out in definitive agreements (read: make it legal). If you wait until you have a disagreement among the founders to formalize things, you’re too late.
At minimum, these arrangements should include:
- A voting agreement, which details how the company will be controlled and managed. This will govern items that range from appointing members to the Board of Directors to making strategic operating decisions.
- A vesting schedule for equity, stating how equity is earned over time in return for service to the company. Note: make sure you write down equity in terms of a number of shares, not a percent. The meaning of “2%” will change over time—for example, when you raise funding and have to issue more shares to award to your investors.
- A right of first refusal, which states that a founder who wants to sell her shares must first offer them to the company or the other co-founders before selling them to a third party.
The great news? There are resources, like Goodwin Procter’s Founder’s Workbench, which will help you prepare these documents for free.
2. Own Your Intellectual Property
Your company needs to clearly own (or have an adequate license to use) the IP you use to operate your business—especially if your company is technology-driven. The biggest risk to this is if you developed your ideas—or software—while still employed by another company.
For starters, if you or your co-founders started working on your idea while working full-time at another company, you need to review the agreements you have with your former (or current) employers. Often, those documents will contain an “invention assignment provision” which requires you to divulge any inventions that you created during work hours or which used that company’s confidential information, and may grant ownership of that IP to the company. You need to make sure upfront that no one on your team is bound by any provisions that could cause your company’s IP ownership to be called into question down the line.
It’s also not unusual for agreements with your former employers to contain a non-solicit clause (a prohibition on soliciting customers or employees) and a non-compete clause (a prohibition on competing in a similar market). Look out for them—these types of provisions may make it very difficult (if not impossible) for a founder to work on a new start-up in the same space as her old company.
Customers and partners may also insist on having ownership rights in your IP or IP escrow arrangements. Start-ups often have little negotiating leverage with their beta customers, but you should still tread carefully: Giving away these IP rights to your customers can severely limit your ability to operate and your value down the road.
Finally, you need to have your co-founders, employees, and consultants enter into invention assignment, confidentiality, and non-solicitation and non-competition agreements with your start-up (assuming the individual isn’t in a state like California, where these types of agreements aren’t valid). This will make sure that your company owns all of the IP that’s developed at your start-up, and is protected if any disagreements surface later down the road—for example, if a founder or an employee leaves.
3. Protect Your Secret Sauce
On one hand, you shouldn’t be keeping your great business idea to yourself—but you should be careful to only divulge as much information about your company and product as you need to, and to know who you’re talking to when you’re sharing those details. For example, in a conversation with a potential partner, it may be appropriate to discuss your idea (the “what”) but not the execution (the “how”).
It’s important to note though, that this may not be feasible with a prospective client, who will likely want to understand the details of your technology. In that instance, you may want to ask the client to sign a non-disclosure agreement (NDA), a legal contract stating that confidential information about your company and its technology or business practices can’t be disclosed to third parties. This will allow you to share what you need to with your clients, but will protect your secret sauce from being shared with the public or your competitors.
Also, most investors won’t sign NDAs, but it is a good idea to do diligence on an investor (or anyone else for that matter) before providing them with confidential information. For instance, you should know whether a VC has a competing investment in its portfolio and get a sense for how particular VCs have treated confidential information in the past. The easiest way to do this is often to reach out to other founders who have taken funding from the VC in question—they’ll often be happy to share with you how well they’ve been treated by their VCs.
When an NDA isn’t appropriate, you should take steps such as writing “Proprietary and Confidential” on prepared materials, including a date and the name of the recipient. While this won’t give you as much protection as an NDA would, the more you indicate the confidential nature of your ideas and the efforts you took to protect it, the more likely a court is to side with you in any future disputes.
Getting married is fun—and starting a new company should be, too. There will be bumps along the way, but if you’ve focused on the tough decisions and legal work at the outset (rather than addressing them after an issue arises), you’ll be setting yourself up for success.
Nithya B. Das is legal counsel at AppNexus Inc., a venture-backed company that provides real-time technology for online advertising. Previously, she was an associate in the Technology Companies Practice Group at Goodwin Procter. Nithya is also a member of Goodwin Procter’s Founder’s Workbench Advisory Board. When she’s not lawyering, Nithya writes an Indian cooking blog, Hungry Desi, and a kids’ recipe site, Half Pint Gourmet. Follow her on Twitter @nithyadas.
John J. Egan III is a corporate attorney and the Co-Head of the Technology Companies Practice Group at Goodwin Procter, where he works with numerous tech and life sciences companies at all stages of development. John is also a key contributor to the Goodwin Procter Founder’s Workbench, an online resource for start-ups, emerging companies and the entrepreneurial community. In addition, he’s an aspiring founder, having recently launched a craft distilling business. Follow him on Twitter @jeganiii.
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